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Bernanke: The Phony Hero

Claims that Ben Bernanke saved the US economy are wrong...

IN HIS Financial Times article on June 4, the FT columnist Martin Wolf praised Ben Bernanke for saving the US economy and the world from another Great Depression, writes Dr Frank Shostak for the Cobden Centre.

He dismisses various critics of Bernanke as lacking in imagination as to what would have happened had Bernanke and the US central bank not acted.

Central banks, including the Fed are doing the right thing. If they had not acted as they have over the past six years, we would surely have suffered a second Great Depression.

According to Wolf, the central bank's role is to stabilize the economy against financial upheavals. He holds that the source of these upheavals is the credit driven private financial sector of the economy. On this way of thinking the instability that is generated in the private sector can culminate in a full blown economic crisis which disrupts the monetary flow and this in turn weakens economic activity and economic growth. (A weakening in the monetary flow weakens the demand for goods and services and in turn undermines incomes).

The solution to the weakening in the monetary flow is aggressive monetary pumping by the central bank to restore the flow.

Now if the central bank fails to do its job and doesn't intervene, according to this way of thinking, this could lead to an implosion of the monetary flow and in a collapse in economic activity and economic growth.

A major manifestation of such collapse is a sharp fall in economic activity. It is for this reason that once a fall in economic activity is observed the central bank must step in aggressively to reverse the implosion in the monetary flow and economic activity.

Hence all the critics of the Fed that blame it for excessive monetary pumping since 2008 don't really know what they are talking about, argues Wolf.

Granted there is a cost involved in such intervention, but consider the other alternative of not intervening – i.e. the Great Depression.

On this logic America owes a lot to Bernanke for if not for his quick response to the emerging implosion in the monetary flow by now the America would have been in a deep economic crisis.

In a lecture given at the George Washington University on March 27, 2012 Ben Bernanke had already anointed himself as the savior of the American economy before waiting for Martin Wolf.

The Chairman of the Fed said that the US central bank's aggressive response to the 2008-2009 financial crisis and recession helped prevent a worldwide catastrophe.

According to Bernanke, various economic indicators were showing ominous signs at the time. After closing at 3.1% in September 2007 the yearly rate of growth of industrial production fell to minus 14.8% by June 2009.

The yearly rate of growth of housing starts fell from 20.5% in January 2005 to minus 54.8% in January 2009.

Also, retail sales came under severe pressure – year-on-year the rate of growth fell from 5.2% in November 2007 to minus 11.5% by August 2008.

The unemployment rate jumped from 4.4% in March 2007 to 10% by October 2009. During this period the number of unemployed people increased from 13.389 million to 15.421 million – an increase of 2.032 million.

In response to the collapse of key economic data and a fear of a financial meltdown the US central bank aggressively pumped money into the banking system. As a result the Federal Reserve balance sheet jumped from $0.884 trillion in February 2008 to $2.247 trillion in December 2008. The yearly rate of growth of the balance sheet climbed from 1.5% in February 2008 to 152.8% by December of that year. Additionally the Fed aggressively lowered the federal funds rate target from 5.25% in August 2007 to almost nil by December 2008.

Despite this pumping the growth momentum of commercial bank lending had been declining with the yearly rate of growth falling from 11.9% in January 2007 to minus 5.3% by November 2009. As a result of the fall in the growth momentum of lending the growth momentum of money supply would have followed suit if not for the Fed's aggressive pumping to the commercial paper market. This pushed the yearly rate of growth of our measure of US money supply from 1.5% in April 2008 to 14.3% by August 2009.

In his speech Bernanke blamed reckless lending in the housing market and financial engineering for the economic crisis. He also acknowledged that the supervision of the Fed had been inadequate.

According to Bernanke once the crises emerged the Fed had to act aggressively in order to prevent the crisis developing into a serious economic disaster.

The Fed Chairman holds that a highly accommodative monetary policy helps support economic recovery and employment. We hold that various reckless activities in the housing market couldn't have emerged without the Fed's own previous reckless policies.

After closing at 6.5% in December 2000 the federal funds rate target was lowered to 1% by May 2004. The yearly rate of growth of our monetary measure AMS jumped from minus 0.9% in December 2000 to 11.5% by December 2001. The strong increase in the growth momentum of money supply coupled with an aggressive lowering of interest rates set the platform for various bubble activities, or an economic boom.

A reversal of Fed's loose stance put an end to the false boom and put pressure on various bubble activities. The fed funds rate target was lifted from 1% in May 2004 to 5.25% by June 2006. The yearly rate of growth of AMS plunged from 11.5% in December 2001 to 0.6% in May 2007. As it happened the effect of this tightening was felt in the housing market first before it spilled over to other bubble sectors. (A tighter monetary stance slowed down the diversion of real wealth towards bubble activities from wealth generating activities).

Contrary to Bernanke, we suggest that his loose monetary policy didn't save the US economy but only saved various bubble activities, which came under pressure on account of the tighter monetary stance.

Note the loose monetary stance had been aggressively diverting real funding from wealth generators towards bubble activities thereby weakening the wealth generation process. The only reason why loose monetary policy supposedly "revived" the economy is because there were still enough wealth generators to support the Fed's reckless policy. Also, pay attention that all the gains on account of the previous tighter stance have been wasted to support bubble activities.

As long as the pool of real wealth is still growing Fed policy makers can get away with the illusion that they have saved the US and the world economies. Once the pool of real wealth starts stagnating, or worse declining, the illusory nature of the Fed's policy is revealed – note that the economy follows the state of the pool of real wealth. Any aggressive monetary policy in this case is going to make things much worse.

The actions of Bernanke to revive the economy run contrary to the basic principles of running a company. For instance, in a company of ten departments, eight departments are making profits and the other two losses. A responsible CEO will shut down or restructure the two departments that make losses – failing to do so will divert funding from wealth generators towards loss-making departments, thus weakening the foundation of the entire company.

Without the removal, or restructuring, of the loss-making departments there is the risk that the entire company could eventually go belly up. So why then should a CEO who decides to support non-profitable activities be regarded as a failure when Bernanke and his central bank colleagues are seen as heroes that saved the economy?

Bernanke and commentators such as Martin Wolf are of the view that by pumping money the central bank had provided the necessary liquidity to keep the financial system going.

We suggest that this is false. What permits the financial sector to push ahead is an expanding pool of real wealth. The financial sector does not have a life of its own; its only role is to facilitate the real wealth that was generated by the wealth producers. Remember that banks are just intermediaries; they facilitate the flow of real wealth across the economy by means of money (medium of exchange).

By flooding the banking system with money one doesn't create more real wealth but on the contrary depletes the pool of real wealth. Most commentators are of the view that in some cases when there is a threat of serious damage to the financial system the central bank should intervene to prevent the calamity, and this is precisely what Bernanke's Fed did.

We suggest the severe threat here is to various bubble activities that must be removed in order to allow wealth generators to get on with the job of creating wealth. If a lot of bubbles must disappear, so be it.

Any policy to support bubbles, be they large banks or other institutions, will only make things much worse. As we have seen, if the pool of real wealth is not there a central bank policy to prop up bubbles will make things much worse, after all the Fed cannot generate real wealth.

Bernanke's policy, which amounts to the protection of inefficiency i.e. bubble activities, runs the risk of generating a prolonged slump with occasional rallies in the data. It could be something similar to Japan (that Bernanke himself has in the past criticized).

We can conclude that, contrary to various commentators, Bernanke's loose policies didn't save the US economy from a depression but have damaged the process of real wealth generation.

Bernanke's loose policies have provided support to bubble activities, thereby destabilizing the economy. So in this sense his policies have saved the bubbles, thus undermining wealth generators. We suggest that the more forceful the Fed's response to various economic indicators is the more damage this does to the pool of real wealth. This runs the risk that at some stage the US could end up having a stagnating or worse, declining, pool of real wealth.

If this were to occur then we could end up of having a severe economic slump. If any one needs examples in this regard have a look at countries such as Greece, Spain and Portugal.

Over a prolonged period of time the policies of these countries (an ever growing government and central bank involvement in the economy) have likely severely damaged the heart of economic growth – the machinery of wealth generation. Again, if the pool of real wealth is to become stagnant, or worse, starts declining, any attempt by the Fed to make things better is going to make things actually much worse by depleting the pool of real wealth further.

Built on anti-Corn Law radical Richard Cobden's vision that "Peace will come to earth when the people have more to do with each other and governments less," the Cobden Centre promotes sound scholarship on honest money and free trade. Chaired by Toby Baxendale, founder of the Hayek Visiting Teaching Fellowship Program at the London School of Economics, the Cobden Centre brings together economists, businesspeople and finance professionals to better help these ideas influence policy.

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